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What Is 'Segregation of Duties'?

• Segregation of Duties is a system designed to prevent theft and fraud.
• The core principle of Segregation of Duties is multiparty verification: when every part of the system is overseen by more than one individual, theft and fraud are more difficult to commit and easier to notice.
• No individual in an organization should be able to complete all four processes of a Transaction: authorization, custody, record keeping, and reconciliation.

Josh Kaufman Explains 'Segregation of Duties'

The larger and more complex a business becomes, the easier it is for employees, contractors, and vendors to embezzle funds, steal merchandise, or otherwise defraud the business.

Accountants and finance professionals rely on a system called Segregation of Duties to prevent all sorts of shady activities. The system, which is intended to reduce cases of fraud and theft, limits a single person’s ability to complete the following business processes:

1. Authorization: reviewing, approving, or overseeing a Transaction.
2. Custody: receiving, accessing, or controlling any assets related to that Transaction.
3. Record keeping: creating and storing accounting records related to each Transaction.
4. Reconciliation: verifying that two sets of records, like internal company Transaction records and external bank statements, match with respect to timing and amount.

The core principle behind Segregation of Duties is multiparty verification: no individual in the organization is able to complete all four of these processes concerning a single Transaction. In most cases, any specific person might be able to complete one or two of these activities on their own, but the rest must be done and/or verified by another individual.

The classic example of multiparty verification is common corporate banking practice: any check, bank transfer, or other instrument of payment above a certain threshold requires the signature of two authorized officers of the company. Unless two signatures are present, the payment isn’t valid and is flagged for investigation.

This simple rule prevents all sorts of financial shenanigans. What prevents a CEO from deciding to double their own salary without approval from the owners or the board of directors? Easy: authorization of the increase by the payroll manager, along with records kept by the payroll system, which can be used to identify and prove the CEO’s misconduct.

What prevents the payroll manager—who has direct access to the payroll system—from doubling their own salary? Cash Flow Statements and Internal Controls by company executives, which can expose a higher-than-expected expense the payroll manager can’t hide.

What prevents the CEO and the payroll manager from conspiring to increase both of their salaries without approval? Bank statements and Transaction records, which can signal to the chief financial officer (CFO) or other executive officers that something fishy is going on. Every part of the system is overseen by more than one individual, so misconduct is more difficult to commit and easier to spot.

Segregation of Duties is also useful when dealing with physical assets and cash. Having more than one person responsible for ordering, receiving, and keeping records of every order and delivery makes it more difficult to divert money or assets in inappropriate ways, since the scheme would require more than one person to cooperate. Ordering and inventory fraud is more difficult to get away with if there’s another individual who’s expecting to receive an order that doesn’t arrive or is charged with auditing the inventory records to ensure everything is accurate.

Most fraudulent activity occurs when someone in a position of Power or responsibility recognizes the potential opportunity to cheat and believes there’s a low probability of being detected. Segregation of Duties is a simple and direct way to reduce fraud by cutting it off at the source: it reduces potential opportunities for misconduct, raises the probability someone will discover the wrongdoing, and increases the number of people who would have to work together to defraud the business.

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"The challenge for capitalism is that the things that breed trust also breed the environment for fraud."

James Surowiecki, American business journalist

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